Waking up Australia

[WHO] Professor Ross Garnaut, one of Australia's most influential thinkers.

[WHAT] His new book Dog Days: Australia after the Boom is a wake-up call to the nation.

[HOW] We need reforms now to avoid slumping living standards and widespread unemployment.

During the past quarter of a century, many people throughout the world have been prepared to risk their lives to have the opportunity to approximate the lifestyle many Australians perhaps take for granted.

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For much of that time – 22 years and counting – the Australian economy has expanded without recessionary pause, creating, in the view of today's guest in The Zone, a "great Australian complacency".

Ross Garnaut, professorial fellow of economics at the University of Melbourne, is one of the most influential public policy thinkers in Australia, with expertise in government, business and diplomacy.

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He believes Australians' living standards will slump and unemployment will rise unless some fundamental changes are made quickly. Garnaut's wake-up call is underscored in the very title of his new book, Dog Days: Australia after the Boom (published by Redback).

During our discussion, the full transcript of which and a short video by Garnaut are at theage.com.au/federal-politics/the-zone, he explains that should Australia fail to boost competitiveness and productivity – the amount produced by a given level of labour and capital – the most vulnerable Australians will be hit hard. He will be online for an hour today to respond to questions and comments from the audience.

Garnaut argues the most important change required is a sharp reduction in the value of the Australian dollar. A high dollar diminishes Australia's competitiveness by making imports cheaper and exports more expensive.

He believes the Reserve Bank should help push the dollar lower by cutting interest rates further. This reduces demand for the currency, and therefore its exchange rate, because it makes Australian-dollar-denominated financial instruments – primarily shares and bonds – less attractive to foreign investors, as they earn a lower return.

"Through the resources boom, our real exchange rate increased by 70 per cent compared with the average of the first 20 years of the float – 1983 to 2003. No developed country, certainly not Australia, has ever had that sort of decline in competitiveness."

In recent days, leaders of the Reserve Bank, including governor Glenn Stevens, have indicated the central bank's desire to see the dollar fall, which it can do with lower interest rates and by selling Australia dollars.

Garnaut says the dollar needs to fall to somewhere between US63¢and US84¢. It peaked at $US1.05 earlier this year and is currently around US91¢.

A lower dollar is crucial, but he argues we also need to boost productivity, and he sets out in the book measures to do this across the economy.

He also advocates reforming federal/state financial relations, so that one or another tier of government is solely responsible for funding and delivering services. He suggests the federal government might leave transport and education to the states but entirely run health and indigenous affairs.

Garnaut believes the end of the China-led boom in demand for Australian exports – which swelled workers' incomes and Treasury coffers – means the government can either spread the adjustment to lower income growth fairly across the community or can protect vested interests and unsustainable tax and other concessions for a privileged few.

He warns, too, of the political difficulty our new government will face explaining the need for change – and in delivering it – but says failure to act would lead to undue suffering. He says the government has a choice between "business as usual" or adjusting policy "in the national interest".

"There has to be a clear perception across the community that what is being done is fair . . . A democratic polity will never support a government that, for example, is systematically entrenching privilege for high-income parts of the community and asking for sacrifice from the rest of the community . . .

"That's where we are now heading – with the continuation of the great Australian complacency we're heading towards the entrenchment of business as usual, with big economic problems down the track."

Garnaut believes the Howard government should have saved far more of the substantial increase in revenue as a buffer against the inevitable end of the mining investment boom, which peaked in 2011, rather than spending it on tax cuts in a nation that by international standards has relatively low-taxing, low-spending governments.

Garnaut cites the generous treatment of superannuation – people can pump money into superannuation at a low rate of tax and take it out later tax-free – as an "egregious" example of a privilege the wealthy have come to see as an entitlement.

Another change he advocates is lowering the cost of doing business in Australia by ending monopolies and oligopolies – where a small number of firms dominate a market. Australia's banking and retail sectors, for example, are dominated by a small number of companies.

Costs should be reduced, too, by real wages pausing until rises are justified by higher productivity. Australia's productivity growth has picked up slightly in recent years, but had been all but stagnant for years.

This meant the illusion of high living standards was created by an unsustainable housing and consumption boom financed by consumer debt supplied by banks borrowing from international capital markets.

"Early reform is much better, and if that view forms through a substantial enough part of society, it makes it easier for political leadership. The consequences of continuing on the path we have been on since the beginning of the century leads to a bigger reduction in economic output and incomes, but also a terrible distribution of those because it will come out as high unemployment."

As the chief economic adviser to prime minister Bob Hawke for 2½ years from 1983, before serving for four years as Australia's ambassador to China, Garnaut was intimately involved in reforms that are widely seen to have unshackled the Australian economy from distortions in the markets for capital, labour, foreign exchange and goods and services.

Pivotal changes included the floating of the dollar and reductions in trade barriers and the unduly high protection of inefficient industries. These were followed by the introduction of a national retirement incomes scheme by the Hawke and Keating governments and of the goods and services tax by the Howard administration. During this period of reform, rising incomes were fuelled by increases in productivity.

Having been chairman of several companies including BankWest and Lihir Gold, Garnaut also brings a business perspective to public policy. He argues that since 2000, reform has essentially ceased and that the growth in the economy has come primarily from demand for our exports, particularly coal and iron ore, driven by China's investment in urbanisation and industry.

Garnaut believes national complacency is one of the greatest threats to our prosperity, and has led to a sense of entitlement to unbroken growth in incomes, jobs, economic output and the fully funded provision of public services when the proportion of people in work is falling and the population is ageing.

Another threat Garnaut examines in detail in Dog Days is climate change caused by greenhouse gas emissions generated by human activity.

He is well placed to comment, having been appointed in 2007 to advise the government on climate change policy. He argues the new government's policy of "direct action", central to which is paying polluters taxpayers' dollars to reduce emissions, is not only an expensive way to meet reduction targets, but will restrict the government's ability to meet its avowed goal of creating budget surpluses.

This is because of the combined effect of the ongoing spending that will be required if Australia is to meet its target of cutting emissions by 5 per cent by 2020 from 2000 levels – and perhaps by much more if other nations go for bigger cuts – and the loss of revenue from the sale of carbon permits.

"You end up with the abolition of carbon pricing being the largest single of the myriad barriers to eventually balancing the Australian budget."

He says the existing policy – which the Abbott government has introduced legislation to repeal – of moving to an international, market-based price on carbon is the most efficient and effective mechanism to reduce emissions.

Garnaut has a formidable record as a policy reformer, but he might not be right about the looming crunch; it is possible the European and US economies will surge unexpectedly or some other unforeseen events fatefully may intervene.

But the logic of his position that the end of the China boom means we need to react seems unimpeachable.

The new government says it does not want the unprecedented unbroken economic expansion to end on its watch. If its rhetoric suggests this can be done without sharing the burden of a short-term adjustment to slower growth in incomes, we should be not just alert, but alarmed.

Full transcript: Ross Garnaut in The Zone

Michael Short: Professor Ross Garnaut, welcome to The Zone and thank you for your time.

Ross Garnaut: It is good to be here, Michael.

MS: You are here because you have just published a book, Dog Days - Australia after the Boom. First, bravo, if I may, for a lively and timely wake-up call in a nation that, as you point out, has become dangerously complacent. You talk of "the great Australian complacency", and we will come to that. As Malcolm Turnbull noted in launching the book, it is, perhaps paradoxically, easier to manage reform at times of adversity than at times of plenty. Before we get into specifics, can we start, please Ross, with an overview? And clearly China is pivotal in this. Can you describe the crossroads at which Australia finds itself today?

RG: Yes. I point out in the book that Australians face a pivotal choice in the months and years ahead between what I describe as business as usual - acting as if we don't have a serious problem - and developing a new approach to public policy, new for the time being, built on pursuit of the public interest.

The problem arises because we have been through a period of extraordinary prosperity. The second half of it is the result of things that don't come from achievement or effort, and we have come to associate that prosperity with inalienable rights of being Australian, rather than the efforts that are actually necessary to sustain them.

We have been through 22 years of unbroken economic growth, unbroken by recession. That is unprecedented in a developed country, certainly unprecedented for us, and I don't think you can find other developed countries that have had that experience.

So that naturally has a consequence for political culture. The first half of this period - from the recovery from the recession of 1991 to the end of the century - saw the prosperity built on something that is sustainable, productivity growth. For part of that period we had the highest productivity growth in the developed world, after having lower productivity growth than most of the developed world through most of the 20th century.

So that was an extraordinary period, built on the reforms that began in 1983. We lost a little bit of momentum in the recession of 1991 but the reforms, in one way or another, continued through to the end of the century, so one could say that the first, say, nine years of the sustained prosperity was built on sustainable elements.

Then we went through a period in which we maintained incomes growth through a housing and consumption boom, funded overwhelmingly by our banks borrowing in global wholesale markets and feeding money back through mortgages for consumption and housing. Australian household savings just about disappeared - in fact for a while did disappear, and became negative.

Consumption grew extraordinarily, and investment in housing grew extraordinarily, and for a while things felt pretty prosperous. That was going to come to an end in about 2004 or 2005. It was a story that had much in common with the unsustainable housing and consumption booms of other English-speaking countries and Spain, which culminated in the global financial crisis.

We were headed into pretty hard times at the end of that - not quite as bad as the United States, the United Kingdom, Spain, and Ireland because we had never had the extreme of deregulation of the financial sector that those countries had had, and our central bank and our other regulatory agency, APRA [the Australian Prudential Regulation Authority], had been jawboning the consumers about housing inflation getting out of control in the mid-2000s when housing and consumption were still being talked up in those other places.

So there was a little bit of a correction here as a result of different policies, but the story has much in common with the others and we could have expected the great crash of 2008 to have had similar consequences here for similar reasons to that in the United Kingdom, the United States, Ireland and Spain if it had not been for the coming of the China resources boom.

We began to feel the benefits of that with rising export prices from about 2003. They kept rising every year until 2008. The dimensions of this were colossal. By the peak, they had lifted average Australian incomes by something like an eighth, without productivity improving at all. In fact, this was a period in which productivity growth ended. Most of it came as government revenue, because when the prices of the iron ore and coal rise they show up in the profits of enterprises.

Workers in those industries get a bit, shareholders get a bit, but most of the shareholders are foreign in the resources industry, 75-80 per cent, so the big way in which the Australian economy is affected is through corporate income tax and other taxes - royalties of state governments, capital gains taxes and some withholding taxes.

So we had extraordinary growth in government revenue from those high prices - mostly to the Commonwealth government but also state governments, first of all Western Australia and Queensland, were doing well out of it, and also NSW and Victoria through stamp duty on housing. We had this huge growth in government revenue and it was nearly all spent. We did have small surpluses in the budget, but that was mostly lags behind the growth of revenue before the spending of it. Most of it went out the door as tax cuts – business and household tax cuts – and as increased expenditure by governments of various kinds.

Some big distortions were introduced into the tax system during this period; perhaps most egregious was the privileged treatment of superannuation.

MS: I want to interrupt there, if you will excuse me, and pick up on that, because I know that some wealthy people are embarrassed by, and almost ashamed of, that which you have just mentioned - but they would be stupid to not take advantage of it, because it is the law. But is this something that ought to be on the reform agenda, and we will come to the more broad reform agenda later, but is that something we should change and could be easily changed because, as you say, it is so egregiously wrong?

RG: I think it has to be changed if we are going to make the adjustment that faces us now. But at the time it was just part of a general expansion. And the effect of spending the increased government revenue as it arrived was to hugely increase the Australian cost level.

Economists measure that through the real exchange rate, the real effective exchange rate, which takes into account what happens to the exchange rate itself but also the cost level compared with other countries, and productivity compared with other countries.

Through the resources boom, our real exchange rate increased by 70 per cent compared with the average of the first 20 years of the float - 1983 to 2003. No developed country, certainly not Australia, has ever had that sort of decline in competitiveness. An increase in the real exchange rate is the other side of the coin to a decline in competitiveness, and there are huge consequences of that.

From the beginning of the reform era, we started to see, and then got in spades, a diversification of our export sector of historic importance.

We saw very strong growth in exports of manufactured goods, even stronger growth in services - led by education but also tourism, business services, engineering services, medical services - while resources and agriculture did okay.

And so by the end of the reform period at the end of the century, we had four large sectors contributing more or less similar proportions of our exports: resources, agriculture, manufacturing and services. We had become a more diverse economy. Well, that all stopped as the real exchange rate started to rise.

We had, for example, once been a net importer of alcoholic beverages. We loved our Scotch whisky and French champagne. But in the reform era, by the end of the century, we had become a large net exporter of beverages, mostly wine, to the extent that this rather small industry contributed the equivalent of about $5 billion in today's dollars to net exports, after taking away imports.

Well, by the latter stage of the resources boom, we were drinking it all ourselves again. We had become as small a net exporter of wine as we were at the beginning of the reform period. And if you look at virtually any of the non-resource exports, you see the same story. You see the same story in tourism. You see the same story in education, which reached a peak in terms of numbers of students in 2011 and started to decline.

Exports of other services have fallen, manufactures even more dramatically. We were able to maintain full employment and growing incomes because we were just spending the largesse from this unsustainable boom. That was all broken for a bit by the great crash, and that interfered with the narrative.

It did actually make sense to spend a bit more to keep employment going at the depth of the great crash in 2008 and 2009, and I am not a critic of what the government did in the immediate response to the financial crisis. We started pulling back that expenditure about a year too late, but we ended up pulling it back at a reasonable rate after that. But it was a year later than would have been ideal.

After a while, the big increase in export prices started to encourage high levels of investment in the resources sector, which really got under way after the great crash - and so that reached a peak a bit later, in 2013. 2011 was the peak of the prices boom.

The prices and investment booms were all followed by a boom in export volumes, which will continue for a while from the resources sector. But that is just balancing off the weak performance of other exports, so while it's a big resources export boom, it's not a big export boom. It is nowhere near as important for employment and incomes of Australians as the first phase of the boom. So the peak of the resources boom was 2011 and it has had a negative impact on incomes and employment as it has come down from the peak since then.

The Australian resources boom and its decline is, above all, a China story. You asked about China and it's taken me a while to get there. China has been growing strongly since it embarked on reform and opening to the outside world about 35 years ago. But there have been a number of different periods in that growth. For the first half a dozen years, reform was focused on rural reform, and growing rural incomes, which was politically extremely important.

It really established the political base for everything that came later, and established the legitimacy of the reform-oriented Communist Party leadership that later took reform into much wider areas. From about 1984, the focus of reform shifted to urban reform and reform of foreign trade and foreign investment.

That was extremely difficult. It meant confronting a lot of profound shibboleths within the Communist Party. Still at that time, economics teaching in the universities was based more on Marx and Lenin, particularly Marx, than on the Western classics. And so China had from about 1985 to 1992 a period of urban reform and export and investment-led growth, above all investment-led growth.

But alongside that, it was groping for an ideological and institutional basis for far-reaching market-oriented reform. And it was a tough time while they were searching through that. And during that time, of course, after I was ambassador, you had the massacre of 1989 and all of the disappointment of hopes and all of the confused thinking associated with that.

By 1992, that period of search for an institutional and ideological basis for deep market-oriented reform and integration into the international economy had come to an end. The key figure in settling the ideological ferment down was one Deng Xiaoping, the senior leader who had been very important in the earlier discussions on reform and was by now an old man but a man of great authority from his role as a successful general in the revolution, his closeness to Mao and other leaders, despite falling out with them from time to time through the period when government was led by Mao.

And he had strong support within the military leadership, members of which placed a lot of value on order and stability after the chaos of the Cultural Revolution and tended to see Deng as the leadership instrument of order. In 1992, Deng settled all of that down and the rest of the party leadership settled in behind him and the formula from then on was a strong emphasis on internationally oriented growth and a growing role for the market and uninhibited priority for investment in support of economic growth.

But there were pretty clear strictures on expansion of political freedoms and development of different political institutions. The authority of the Communist Party was no longer to be questioned after a number of years in which questions had been asked.

MS: And just mindful of time, as there's a lot I want to get through, that is what also led to the complacency that you're talking about.

RG: Yes, that gave us the investment-led growth. But at first through the rest of the 1990s it was consistent with an expanding role for the private sector.

But the two events that combined with that focus on investment-led growth to give us our China resources boom were the responses to the external financial crises - first the Asian financial crisis and then the great crash of 2008. China took a bold decision through the Asian financial crisis not to allow the devaluation of its currency when all of its neighbours, including Japan and Korea and Australia, had experienced huge currency depreciations.

It pegged its currency against the United States and stuck there. That led to a decline first in export growth, and briefly in exports, and was damaging to employment. So China maintained employment with a huge Keynesian expansion - and that was money pushed out through state-related entities, and that reinforced the role of the big state enterprises, which tended to favour infrastructure, heavy industry and steelmaking.

That was very good for demand for metals and energy. And then that was followed up by a similar and even bigger response to a bigger external shock in 2008 – the great crash to which the response was again increased investment through state-related enterprises. Now, both of these Keynesian responses were brilliantly successful. They kept economic growth going in China, kept employment growing in China, and they helped put a floor under the downward spiral in the one case in Asian economic activity and in the other case in global economic activity.

It was very important to Australia in both cases. But together they entrenched and expanded the role of the old-style state development, which was heavily metals-intensive and energy-intensive. Investment rose to higher shares of expenditure than had ever been known in an economy of substantial size.

And that used metals very intensively, first of all steel, and energy very intensively, first of all coal. And especially after the second Keynesian response, after the global financial crisis, you had very strong growth in import demand for all these products.

That took international markets by surprise. International suppliers of these goods, including the big Australian resource companies, had not been expecting it, and so for a long time you had demand running ahead of supply and so there were very high prices. And the big increases in investment to supply more of these things came after the boom was well under way.

MS: And that has peaked, as you said in 2011, and now we are facing this crossroads that you describe as business as usual or public interest.

RG: I should say just a couple of sentences about the peaking. It was partly the natural consequence of the growth process itself. The success of that old-style Chinese investment-led growth meant that labour became short and scarce and wages started to rise from about 2004.

By 2010 or 2011, that was starting to affect the overall pattern of growth, and you started to get more consumption because workers had more in their pocket. And secondly, the society and the Communist Party started to become more anxious about some of the by-products of that pattern of growth.

There was terrible pollution in the Chinese cities, especially associated with the burning of coal, and terrible growth in Chinese contributions to the global greenhouse gas problems. And there are plenty of good scientists in China, plenty of people near the top of global science, with the ear of leaders of government, like in most countries.

So the Chinese leadership knew that China was contributing to a serious global problem. And a combination of these concerns and with the way the old pattern of growth was exacerbating income inequality in China and developing political tensions associated with that, meant that from 2011 you had deliberate attempts to modify the growth package.

By 2012, it was becoming influential - so that from 2012 you can see less metals-intensive growth - less energy-intensive but, above all, less coal-intensive growth. And that was just at the time when the investments by Australian and other global suppliers were beginning to push more iron ore and coal into global markets.

And that started to push down prices, and since then we have had to face a different and less wholesome reality.

MS: And part of the reality in policy and politics and economics and markets is the existence of lags and the effect of lags and the response to lags, and so we are now at this crossroads - business as usual or public interest. And we have a new government. Your book, Dog Days, has a wake-up call in its very title, doesn't it? Business as usual and public interest as options are almost binary, but politics is the art of compromise and policy is, notwithstanding Paul Keating's love of classical straight lines, not necessarily always done that way. Do you see a policy-option spectrum between business as usual and public interest? Or is it a binary proposition?

RG: I think we face very large problems, and so a lot of large things have to be done, and they won't be done through incremental changes in what we're doing. They require big changes in policy, and they are only going to be possible if there is big change in political culture.

MS: Okay, so let's look then at what the reform agenda is, or what you think ought to happen in light of the reality that you have described, and the historical context within which it has occurred, as you have described. Where do we need to go from here, in your view?

RG: Right at the centre of what is required to maintain full employment - or high employment, as we have already lost full employment - and the highest feasible living standards consistent with full employment is that we have got to reduce our cost level relative to the rest of the world. We have got to depreciate the real exchange rate.

The more we can get from productivity growth the better, and I talk quite a lot in the book about the things we can do to improve productivity growth, and they are all hard. But when one looks realistically at how big our decline in competitiveness has been, how big the appreciation of the real exchange rate has been, you can see that even if we did brilliantly successfully with productivity and went back to where we were in the 1990s - say a percentage point per annum better in productivity growth than the rest of the world - it is going to take generations to claw back what we have lost in competitiveness, and we don't have that time.

So there has to be a big fall in the real exchange rate, and that has to come first of all through the ordinary exchange rate you see on the television every night coming down. But that is not the end of the story. You have to stop that passing through into incomes growth.

And in the great Australian complacency of the early 21st century, all sorts of elements of Australian society have come to feel that their current privileged positions are sacrosanct - that any reform to take any of that away amounts to sovereign risk.

MS: Do you think we have got a collective sense of entitlement going on?

RG: Yes, very strongly. If you look at numbers of dollars of what's happened since the turn of the century - some of the areas of business monopoly, executive remuneration, guaranteed rates of return in regulated monopolies, these are very important to the adjustment we have to make.

And also soft taxation arrangements, where we have been giving away both corporate and household taxation benefits that, in many cases, are not important for economic efficiency, which don't contribute to economic growth and employment growth and therefore just weigh down the living standards of everybody who doesn't benefit from them.

MS: And you have mentioned the superannuation situation. Are there other examples you would like to note?

RG: I would put the mineral tax into that, and I drew a contrast between the way the mining industry reacted to the rather ill-conceived reform proposals of 2010 and the way they reacted to what Malcolm Fraser did in the 1970s in response to the big increase in oil prices at that time.

It's chalk and cheese in terms of political reactions. Now, the government badly mismanaged the resources tax, and I discuss that at some length in the book, but one can't lose sight of the fact that the political response was extreme and was built around entitlement - built around the idea that if a business benefits from some mistake in economic policy, a government is not entitled to reform that to take away those gratuitous benefits.

MS: Do you think that that was an example of the notion that in public policy and in life generally the pig with its snout deepest in the trough squeals loudest when you try to pull it out?

RG: I hadn't thought of that metaphor, but one could see its relevance in the circumstances. It will be necessary if we are to maintain full employment with as high as possible incomes and living standards through the period ahead, for adjustments in living standards right across society. There will need to be adjustments of household incomes, and workers' real incomes. These sorts of adjustments are politically difficult.

MS: Although when we're talking about lower exchange rates, that is not so much politically difficult as mechanically difficult, perhaps - and that is associated with lower interest rates.

RG: But prices rise because the exchange rate has risen.

MS: Through the import mechanism.

RG: Yes. The prices of shirts and shoes and cars and petrol and I suppose these days we had better say iPads and iPhones and holidays in Europe, they will all go up, and many people in our society will think that they should be compensated for that, but if everyone is compensated, we don't get any improvement in competitiveness.

MS: So another way of looking at this crossroads is that we either take a collective big hit down the track, or in the shorter-term share the pain of the adjustment, fairly and decently involving some reform, and pick it all up on the way through?

RG: That's right. And it will involve a lot of reform. And we know from our own history and that of other countries, that you don't get adjustments like this working unless there is buy-in across society.

MS: Which requires political leadership to the point of inspiration, doesn't it?

RG: It requires two dimensions of political leadership. One is to explain to the community that some big changes have to occur and why they have to occur and that the consequences of them not occurring will be worse than the consequence of living with the changes themselves.

Secondly, there has to be a clear perception across the community that what is being done is fair. We live in a democratic polity, and I hope we will for ever, and a democratic polity will never support a government that, for example, is systematically entrenching privilege for high-income parts of the community and asking for sacrifice from the rest of the community. It just doesn't work.

MS: And are we at risk of seeing that in the current settings? You have said in the book that neither of the main sides going into the 2013 election was telling it like it should be.

RG: Yes, I think there is a big risk of that. In fact, that's where we are now heading towards. With the continuation of the great Australian complacency we're heading towards the entrenchment of business as usual, with big economic problems down the track.

The consequences of that are so severe for Australians later on that I hope the discussion of the problems will lead enough of us to form the view that the alternatives are much better. That is, that early reform is much better, and if that view forms through a substantial enough part of society, it makes it easier for political leadership.

MS: And Ross you have just said you hope that we continue to live for ever in a democratic system, but one of the shortcomings often noted of the democratic system in terms of public policy development is the short-term nature of thinking because of the three-year political cycle. Are you optimistic that we are going to take what you see as the right fork in the road here, or do you think it is going to be a case of muddle through and react when the pain is sufficiently severe?

RG: If it is muddle through when the pain is sufficiently severe, a lot of vulnerable Australians will feel unnecessary pain, and I would hate that to happen.

MS: So there is a profound moral dimension in where we are in 2013 with political economy in Australia?

RG: Oh, I think so. The consequences of continuing on the path we have been on since the beginning of the century leads to a bigger reduction in economic output and incomes, but also a terrible distribution of those because it will come out as high unemployment.

MS: There is a great Australian expression, and forgive me for using the vernacular to the point of being crude, there is a view, and I think you share it, that reform stopped with the GST in 2000 and since then is it fair to say that we have pissed it up against the wall?

RG: I see it in that way, yes. Now, I am not such a wowser that I see no value in quadrupling our consumption of French champagne, but there are consequences. And we are now living with the hangover of all of that.

MS: And those consequences strike the most vulnerable first and hardest?

RG: Unless we make an adjustment across the society as a whole, in which we maintain employment growth and we set out to make adjustments in taxation and social security that preserve, where we can, support for vulnerable Australians, while doing it in a clever way that maintains incentives for labour-force participation.

It is possible in these circumstances that you will damage the interests of low-income Australians by making employment harder for them to get. There are ways you can help that and I talk about them at some length in the book.

MS: Going back to the sense of entitlement, and one perhaps manifestation of that being, I would argue, the misconception that Australia has big-taxing, big-spending governments. OECD figures bear that out. Ken Henry has argued that we need to look at raising the GST, that we need to lift the tax/GDP ratio to ensure the future of this country through enlightened public policy. Do you have a view on that?

RG: Ken Henry's work, or the Treasury's work when Ken was secretary, drew attention to some of the long-term budgetary consequences of the ageing population. That is going to add 4.7 per cent, on the Treasury figures, to the budget deficits between now and the middle of the century, without any change in policy whatsoever.

MS: So as part of the debate we need to say we're not overtaxed and if we want to have a decent society we need to look at an equitable way of funding that through a slightly higher tax take?

RG: Yes. If you put to Australians the question 'Do you want lower taxes?' and you don't put any other question to Australians, and even if you put to Australians "Do you want lower business taxes on things like resources?" a proportion of Australians will say yes, we should have lower taxes.

But if you put the whole choice to Australians - that we can't afford all the types of services we have now, the social security arrangements we have now, with the current tax rates, without having very big budget problems - in these contexts would you prefer big cuts in services or equivalent increases in taxation of various kinds, you usually get majorities in support of moderate increases in taxation so as to preserve the fabric of public goods and services provided in Australia.

We should have an honest debate about that. The debate has been one in which people wanting lower taxes are just clamouring for that and not talking honestly about the consequences. So we need an honest discussion of trade-offs there. I don't see the preparedness in the Australian community to take big cuts in services that would support a lower percentage of GDP as taxation.

So if there is to be higher proportions of taxation, then we need an intelligent discussion of what forms taxation increases should take. And there are real choices. Get rid of carbon pricing for example and at the same time commit to maintain reductions in emissions that both parties have committed themselves to, you are looking at a hit to the budget beyond the forward estimates, years five, six, seven, eight, you're looking at about $40 billion through the four-year forward estimates period.

MS: Let's use that as a segue to that subject, because I was coming to it in a moment anyway. You have done a lot of work and advising governments about climate-change policy. It seems to me that we have gone backwards. There was bipartisan support for what economists around the world have agreed is the most effective way to reduce dangerous emissions. Where are we today in terms of getting to where we need to be for future generations on this particular policy area?

RG: I think the package of measures that was legislated in 2011 allows us to deal with the problem reasonably efficiently. And one characteristic of that set of policies is that it allows a tightening up of our effort and an increase in that effort over time with minimum disruption.

For example, part of those arrangements is the Climate Change Authority, which is modelled on the British Climate Committee. It has some independence from government and has a strong executive. Its role is to judge what is a fair contribution from Australia, given the international effort.

That is a question that in its nature is always going to be very difficult to settle through purely political processes. So, just as we have taken decisions on protection a step away from the raw political process with the expert role of the Productivity Commission, and we have taken interest rate determination a step away from raw politics with the role of an independent Reserve Bank, there are big advantages in taking assessments of appropriate emissions reductions, given what the world as a whole is doing, a step away from the raw political process.

I think it would be a big step backwards and a very wide range of Australians would come to rue it if the Climate Authority was abolished. But that is part of the 2011 arrangements. The emissions trading scheme is a sound one. The linkage to Europe is sound and will automatically lead to a fairly large reduction in carbon prices in 2015, or 2014 if the Labor Party's revisions are taken into account.

But what is crucial is not what the price is going to be in a year or two, but what are reasonable expectations of it in the longer term, because that's what drives investment decisions. And most informed business leaders would expect European pricing with economic recovery in Europe and tightening of targets to be a good deal higher in half a dozen years time than it is now.

So I think the current arrangements are soundly formed for Australia to make its fair share, its fair contribution, to the international effort at reasonable cost.

MS: The new government's policy though is direct action - $5 billion worth to get the 5 per cent reduction. The strongly emerging view from those, including yourself, who know about this is that $5 billion is not going to be sufficient, but that you can get emissions down by using, as you describe it, muscular activity - the sort of thing that Barack Obama led with four other nations after it didn't happen in Copenhagen, so through Cancun. We have got Paris coming up in 2015. Do you think that the Australian government's policy, and again I do not want to politicise this, do you think that that funding and that policy is going to be sufficient to allow Australia to do what you described in the book as its fair share?

RG: Well there are a lot of dimensions to that. First, you can get very large reductions in emissions through regulatory intervention.

MS: And it's not the cheapest way of doing it, is it?

RG: No. I had a conversation exactly in these terms with Steven Chu, who in the first term of the Obama government was secretary for energy, a Nobel Prize winner in physics who understands climate science better than most of us. He and the Obama cabinet were deeply committed to doing things about climate change. And Obama committed the United States after Copenhagen to reducing emissions by 17 per cent on 2005 levels by 2020.

They had hoped to do that through an emissions trading scheme and they got that through the House of Representatives but it was filibustered in the Senate. Although the Democrats had a Senate majority at the time, under that unique American phenomenon of the filibuster, a minority can avoid something coming to vote. Then once the 2010 mid-term elections changed the complexion of the House of Representatives it just was not possible.

I had a conversation with Steven Chu at that time and he was very helpful to me in my work on climate policy. When I had asked him how the US could meet its 17 per cent target, he said, “Don't worry, Ross, we had hoped to do it through an efficient and low-cost way but Congress has blocked an efficient and low-cost way so we will do it through other ways." And then he went with me through all the regulatory arrangements that the US would introduce.

MS: As you set out in the book, and so I can take people through that. And the point you seem to be making here is that we seem to be heading down the same track and we are locked into it.

RG: Well, we're heading down the same track if we're muscular about it.

MS: And we're not yet even muscular.

RG: No we're not. But if we try to meet our emissions reduction commitments through Direct Action we will have to have the sort of interventions which effectively ban new coal-fired power generators in the United States and will start to put strictures on established coal-fired generators in the United States.

Part of their policy is also to greatly limit exports of gas so that the United States gas price stays a small fraction of the Australian price. We have had an even bigger increase in gas reserves in eastern Australia than the United States has.

MS: And yet our price is about to treble.

RG: Yes our price is about to treble, and theirs has fallen by two-thirds because up to now they have banned exports and now they are controlling exports. That is helpful for emissions. Gas is replacing coal.

Up to now the emissions reductions have come from other things, but now that gas policy is helping. But it is enormously expensive. If we did not have a gas export industry, which would be the consequence of US-style export bans, we would get lower emissions because gas would replace coal, but it would cost us a lot of money.

It turns out to be a very expensive way of reducing emissions. The low-cost way is what we have legislated now. The government has also said it will increase the emissions reduction from 5 per cent if the action of other countries warrants it. And that is not just a nebulous statement; it is quite precise.

MS: Greg Hunt recommitted to that during the campaign.

RG: I have heard it personally from Greg Hunt at a meeting at Melbourne University. The government's policy as stated is not the 5 per cent; it is somewhere between 5 per cent and 25 per cent, depending on what the rest of the world is doing.

There was a very important interview with a member of the consulting firm that works for the government, Frontier Economics, on Lateline ... in which that person described himself as one of a small minority of economists who thinks that you can reach the government's environmental objectives through direct action.

I would say actually that he is in a minority of one that thinks you have good prospects of reaching the emissions reduction target through direct action. There are a couple of other economists who are on the public record as favouring direct action, but that is because they don't believe in trying to reach the objectives.

So Frontier Economics is supporting the government in saying you can reach these objectives through direct action. But he clarified the true situation; you don't get there, or anywhere near there, through the monies committed in these next four years.

Getting to the 5 per cent depends on spending a lot more money, a lot of billions after the four-year forward estimates. So when you add that huge increase in expenditure in years five and six and so on to the loss of revenue from the sale of permits, you end up with the abolition of carbon pricing being the largest single of the myriad barriers to eventually balancing the Australian budget.

MS: We have gone hideously over time, and I could talk for hours with you, but I need to move to the two final questions, which have a bit of a look at you. What motivates you, Ross? Why do you do what you do? Where did it come from, and what influenced you? Why do you believe what you believe?

RG: I am very interested in public policy in Australia and in the countries with which I have had a lot to do - which are mainly countries in the Asia-Pacific region.

From time to time I have been deeply involved in the economies of Indonesia, Papua New Guinea and China and Australia. I have always been interested in economics, because I am interested in economic development broadly defined.

MS: Why?

RG: I don't think you can without prejudice of various kinds divine the origins of one's motivations, but it includes values of parents and it includes youthful experience. As a young man I shared an interest in these things with a number of my closest friends and in various ways we have made careers in those areas.

And then personal friendships with people in each of the countries I've mentioned who have been deeply involved in the policy processes and have struggled with the same questions I have been struggling with. That has reinforced that early interest.

MS: The way I have thought about it over the years is that public policy is where political philosophy and other philosophy and psychology and politics come together within a set of principles, not an ideology, but a set of principles associated with fairness and decency and allowing individuals to explore and thrive.

RG: Those values ideas are the difference between an interest in these areas in public policy and, for example, an interest in science and physics - which as a young man I was also very interested in. Only processes which at first sight look accidental led me away from an early interest in physics.

I was led away actually not by accidental processes; I was led away by being interested in the normative dimension of economics. Intellectually, economics is interesting like the natural sciences - in some ways more complex because you are dealing with human institutions that change over time and not as invariable as the laws of nature, but nevertheless there are similarities in the intellectual appeal.

What makes economic policy and public policy compelling to me is that it is relevant to the quality of society that we humans have to live in.

MS: The final question, Ross, to every guest in The Zone is what is the hardest thing you have ever had to do, at least that you are able to talk about here?

RG: I will talk about hardest things professionally. Probably in my early days as a senior officer of Papua New Guinea government in the year or two after independence, asking my close colleagues to face up to some of the choices these societies would have to make about corruption - the role of money and the corruption of private motivation through money in the policy-making process. Early leaders in Papua New Guinea had to choose between becoming rich and setting their families up well for generations, and setting the country up for successful development.

MS: Thank you very much for your time today. I wish you well with the book, and I wish you well with your ongoing contribution to Australian public policy.

RG: Thanks Michael. Well, I have put it all there in this book, Dog Days, and I am hopeful that that will play a role in Australians coming to grips with the seriousness of the choice we have to make.